When the Federal Reserve got wimpy on inflation in the 1990s, "vigilante" bond traders threw a fit, rocked the market and made everybody wonder who was really in charge.
Meet the vigilante stock market. Yesterday's interest-rate cut - the first emergency reduction since right after September 2001 and the largest one-day drop since 1984 - was a panicked attempt to appease angry stock traders. So again, somebody else is calling the Fed's tune.
The difference is that, unlike the fussy 1990s bond market, stock vigilantes are forcing the Fed to drive interest rates down instead of up. That's a recipe for inflation that, in the long run, could create the worst possible world for bond owners, shareholders and consumers alike.
Afraid of being perceived too clearly as a stock market flunky, the Fed didn't mention the worldwide stock market plunge as a reason for cutting rates. But the connection couldn't have been clearer.
If Fed boss Ben S. Bernanke's main concern really were "a deepening of the housing contraction as well as some softening in labor markets," as the Fed stated, he could have waited until the regular rate-setting meeting next Tuesday.
On Monday, however, stock markets fell 7 percent in Germany and France, 6 percent in Britain and Hong Kong and 5 percent in China and Canada.
U.S. markets were closed for the holiday honoring Martin Luther King Jr., but futures trading suggested that the Dow Jones industrial average would follow them down yesterday and perhaps post its largest point drop ever.
The Fed beat it to the punch before the markets opened, cutting the critical federal funds rate - what banks charge each other for overnight loans to maintain required reserves - to its lowest level since 2005.
To reduce rates, the Fed buys debt, injects money into the economy and theoretically makes it easier and cheaper to get loans. But bathing the country in money can also fuel inflation. A lenient Fed under Chairman Arthur F. Burns set the stage for 11 percent inflation in the 1970s by leaving rates too low for too long when energy and food prices were gurgling up, as they are now.
A desire to appear tough on inflation may have prompted Bernanke to wait to get serious about lower rates. Some of his Fed colleagues seem less than confident that inflation won't take off. Chief among them is William Poole, president of the Federal Reserve Bank of St. Louis, who cast the lone "no" vote on yesterday's rate-cut decision.
Reducing rates by baby steps last fall - and messing around with unorthodox tactics such as auction-loans for troubled banks - may have been a bid to placate hawks such as Poole and keep prices under some control.
But this either delayed the inevitable or kept money so tight that even bigger cuts became necessary as the economy continued to deteriorate. The Fed cut rates yesterday three-quarters of a point. Some analysts believe it could cut another three-quarters next week. That would get short-term rates down to 2.75 percent, well on the way toward the historic lows of 1 percent reached a few years ago.
And we all saw what that led to.
Low interest rates in the 1990s caused the stock market bubble and collapse, which required the stimulus of low rates in the early 2000s, which caused the housing bubble and collapse - which is again requiring low-rate defibrillation. What'll be the low-rate side effect this time?
The stock market, a whiny kid who throws tantrums when broccoli is on the table, calmed down when Bernanke dished out the candy. The Dow was down 465 points early yesterday but ended up falling 128.11.
But nowhere in the Fed's charter does it say anything about bailing out stock investors. As the country's premier banking regulator, the Fed's job is to ensure that consumers and businesses can tap credit as part of an effort to promote high employment and low inflation. There may have been a compelling case under that standard to slash rates yesterday, but that's not what you heard from the Fed.
Instead, the Fed seemed surprised, reactive and obedient to Wall Street. The nation's central bank must inspire more confidence than that to keep consumers and businesses spending and investing.
If they falter and we dive into recession, the stock market won't be happy, either.